Watching What the Fed Is Watching in 2016

By

Tony Crescenzi

January 18, 2016

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By

Tony Crescenzi

January 18, 2016

After the Federal Reserve’s 25 basis point (bp) December increase, investors are now turning their attention to 2016 and to the entirety of the Fed’s interest rate cycle. PIMCO concurs with markets on the ultimate speed and distance of the Fed’s path on rates, which is widely expected to be slow and shallow.

Our base case is for the Fed to announce three 25 bp rate increases in 2016, consistent with where the central bank’s core leaders have indicated they are leaning, but greater than the two rate hikes that the bond market is priced for.

So, what should investors be looking at to estimate how many rate hikes the Fed will actually deliver in 2016? There are three things in particular: 1) labor market trends relative to the Fed’s projections, 2) inflation trends relative to the Fed’s projections and 3) the amount of rate hikes the Fed’s core leaders expect in 2016 if its economic projections are correct.

Of the three factors, probably the easiest to analyze and translate into the likely number of Fed rate hikes is the labor market, mainly because the Fed provides a quarterly Summary of Economic Projections (SEP) to serve as a guidepost to judge the Fed’s satisfaction with the progress occurring on the jobs front (see Figure 1).

Utilizing these projections to prognosticate the Fed outlook for 2016 is fairly simple. Basically, if job growth exceeds the Fed’s projections, there could be more rate hikes than the Fed’s leadership currently expects (four increases instead of three). If weaker, the Fed could move less than the leadership expects (two or fewer times). The odds of five quarter-point hikes look a lot lower than the odds of two under current circumstances, especially with the Fed now placing greater emphasis on realized (versus projected) inflation.

To be even more specific with respect to how to translate labor market trends into the likely number of Fed rate increases in 2016, consider both of these elements:

1. Monthly payroll growth 2. The pace of decline in the U.S. jobless rate

On the first factor, it is very important to know that the Fed projects a substantial slowdown in job creation in 2016, owing to a decrease in the amount of available workers and a maturing of the economic expansion, which is entering its seventh year.

Specifically, the central bank projects monthly job growth to slow from the 200,000 or so pace of recent years to about 130,000 per month in the second quarter of 2016, and 100,000 per month by the fourth quarter. As substantial as the decline is expected to be, and as much as it seems reasonable to refrain from tightening monetary policy at all, what will matter is how monthly job creation fares relative to the Fed’s projections, because the Fed will view a jobs slowdown as normal for the current stage of the business cycle. This is how to simplistically determine how the Fed might react to incoming jobs data, assuming all else is equal, which of course it rarely is, so keep a holistic perspective on the broader economic situation (in the U.S. and globally) as well as on financial conditions.

On the second factor, the jobless rate, the Fed expects a decline of just three-tenths of a percentage point (to 4.7%) in 2016, a remarkably small decline compared with the past four years when it fell a full percentage point per year. As with the pace of job creation, the speed of progress in reducing unemployment will have a major bearing on how many times the Fed raises interest rates. If, for example, the jobless rate falls below 4.7%, say to 4.6% or 4.5%, this will raise the odds of four rate hikes. A slower rate of decline would make it more likely there will be three hikes or less, depending upon the speed of job creation, inflation trends and financial conditions.

Predicting what the Fed will do in 2016 is likely to be easier than it has been in quite some time. Start with three hikes as a baseline, and then adjust the expectation up or down primarily based on labor market trends, putting the jobs data in the context of incoming inflation data. Then consider financial conditions, because the movement of stocks, bond yields and the value of the U.S. dollar can all influence the U.S. economic outlook and therefore the Fed’s decisions on interest rates.

For timely insights into global monetary policy and other macroeconomic factors affecting markets and investors, please stay tuned to the PIMCO Blog.

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